Abstract

From a theoretical perspective, Islamic banking and finance is different from conventional banking and finance because interest (riba) is prohibited in Islam. The unique feature of Islamic banking and finance is its profit-and-loss sharing (PLS) paradigm. As such, the equity stock market mechanism follows this unique PLS paradigm without the involvement of riba, gharar and maysir, allowing Shari’a sensitive investors’ access to the stock market. But the problem is to identify the Shari’a compliant equity stocks (that are both Shari’a compliant in the capital structure as well as the underlying business) within the equity stock market. In order to assist the Shari’a sensitive investors, the Dow Jones Islamic Market Index (DJIMI) for the first time in history issued the first Shari’a screening methodology in 1999 that facilitated access to the stock market. Subsequently, a number of other Shari’a screening methodologies have been developed by other index providers, banks and regulators; all of them are derivatives of the DJIMI. The rules used in the screening process have not originated from the Holy Quran or the traditions of the Prophet Muhammad (PBUH), and accordingly are not considered absolute rules. These screening methodologies have been criticised in the literature for being imprecise, inconsistent, lacking credibility and on the use of Shari’a screening thresholds restricting the Shari’a non-compliant activities.
The study is designed to address two main areas: 1) to examine the historical development of Shari’a screening methodologies to date, and 2) to investigate how the existing Shari’a screening methodologies can be enhanced for the benefit of the Islamic banking and finance (IBF) industry. A qualitative analysis is carried out in the first part of the study. A statistical technique of exploratory factor analysis (EFA) is carried out in the second part of the study.
The examination of the first part of the study shows that the fundamental variables underlying existing screening methodologies should be based on actual interest income and interest expense as it’s the actual interest received or paid that is Shari’a non-compliant instead of on the basis of source of funds (debt, receivables). This part of the study also finds that the Shari’a screening methodologies were introduced as a need of the time under Maslahah (public interest and rule of exception). It was expected that scholars and practitioners would review and revise the screening methodologies over time to ensure adherence to Shari’a. However, they have remained the same while the Islamic banking and finance industry has developed significantly. Further examination of current practices, suggested Shari’a screening thresholds to be dynamic and ones based on the growth and development in Islamic banking and finance.
Based on findings of the first part, the study conducted an exploratory analysis in the second part using different portfolios and screened them based on interest income and interest expense and compared with existing practices. It is recommended that Shari'a screening methodologies incorporate these screening filters in addition to the existing filters to ensure that the portfolio remains Shari'a compliant. Further, the study in the second part developed an IBF index using exploratory factor analysis to quantify the development in IBF industry in 41 countries. These countries were placed in five groups (leaders, developed countries, developing countries, emerging markets and least developed countries) and it was concluded that Shari’a screening thresholds for countries based in groups “leaders” and “developed countries” can be lowered to 20% and 25% respectively as the IBF industry in the underlying countries have developed significantly and there are sufficient Shari’a compliant stocks to provide the investor a diversified portfolio, while for other countries the existing thresholds should continue as the IBF industry in the country is still in early growth period and Islamic financing availability in the country is not adequate. In this way, the Shari’a compliant equity investments can go forward in a more effective manner and thus a move towards more dynamic and progressive screening methodologies, rather than the existing static ones.